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Choosing the Right Pond

I find that most people on the left have very few new or interesting ideas. An exception to this generalization is Robert Frank, whose New York Times columns are often a good read. One of his recent columns has sparked a lively debate between Frank and David Friedman at Friedman's blog, with Tyler Cowen and David Henderson also weighing in at their blogs. (And, yes, a lot of the argument has to do with health care.)

Frank's view is that status is very important to people and he uses that fact to make ingenious arguments for (1) a consumption tax on the rich and (2) redistribution of income. (See his book, Choosing the Right Pond, and his Congressional testimony, summarized by David Henderson here.)

Today I'm going to address the first argument. Here's one of my bottom lines: If you agree with Frank's argument, you're compelled to agree that 30 years of Republican tax policy, with an assist from Bill Clinton, is much preferable to what Barack Obama and the Congressional Democrats have done and are planning to do.



Little Boxes

Frank's Argument for a Consumption Tax on the Rich. Frank believes that wealthy people are engaged in a conspicuous consumption arms race. (And although I called him an original thinker, at least this part of his thinking harks back to the writings of Thorstein Veblen, almost a century ago.) One person builds a McMansion to demonstrate his success in life, provoking a neighbor to build an even larger one. To best his neighbor's top-of-the-line BMW, one person buys a Ferrari. His neighbor responds, say, by acquiring an Aston Martin.

Further, a lot of the consumption of the rich is focused on "positional goods." These goods not only convey high status, they are also fixed in supply. Examples include beachfront property, housing lots in good school districts, paintings by dead artists, vintage wines, antique automobiles, etc. As income and wealth grow, the demand for these items grows. But since supply is fixed, ever-increasing demand only leads to ever-increasing prices.

As with any arms race, everyone would be better off if they all declared a truce. Suppose everyone agreed to cut his conspicuous consumption by 50%. Then everyone could maintain his relative status while halving the cost of doing so. But getting everyone to agree would be impossible because of the huge transactions costs. So government can achieve the next best outcome by a percentage tax on the consumption of the rich. Relative status would remain the same (therefore leaving everyone's utility the same) and the new revenue could be spent on something that benefits everyone, including the rich. Building statues to honor great economists, say. (My example, not Frank's.)

Here are some implications of this proposal as well as my criticism:

The Rich are Different. From each other, that is. When Sam Walton was the richest man in the world, he drove a pickup truck. His neighbors didn't even know he was rich until they read about it in Fortune. So under Frank's proposal, the very richest person might not pay any additional taxes. The new tax would only apply to high-dollar consumption.

Implication: Saving and Investment Would Be Exempt. When Warren Buffett buys a yacht or eats an expensive meal he is benefiting Warren Buffett. But when he forgoes consumption and saves and invests he is benefitting you and me. (His capital raises our productivity and, therefore, our wage income.) Frank's argument only applies to Buffett's consumption. So, as in the case of Sam Walton, the vast bulk of Buffett's income would not be taxed.

Implication: Most Positional Goods Would Be Exempt. Despite Frank's focus on these items, positional goods are mainly goods high-income people trade back and forth among each other. Whether the price of these goods rises or falls affects particular individuals, but one man's gain is another's loss. A change in price has no net effect on the income, wealth, consumption or possessions of the group as a whole. Further, if we taxed the sale of collectibles and other assets we would likely reduce the amount of financial capital available to create jobs and improve productivity. So Frank's argument realistically only applies to the purchase of newly produced consumption goods.

Has the GOP Been Listening to Frank? For the last three decades, Republican tax policy (with some interim help from Bill Clinton) has achieved two things: (1) a huge shift in the income tax burden from lower- to higher-income taxpayers and (2) a substantial decrease in taxes on capital. These two changes together imply that an ever-increasing share of government revenue is the result of taxing the consumption of higher-income families.

Although Democratic critics (including the president) have said over and over again that Republican tax policy favors the rich, truth is that virtually all income tax revenues are now coming from the top half of the income distribution. The bottom half pays almost nothing. At the same time, the top rate on capital gains and dividends is only 15% - the lowest tax on capital income in memory. Of course, the government is collecting more revenue at the lower rates (as Art Laffer might have predicted). But the entire object of the exercise has been to shift the tax system toward a tax on the consumption of higher-income families.

Contrast this with the Obama Administration, which is planning to pay for almost all of its health reform by taxing the incomes and reducing the health care consumption of people who are definitely not rich. As part of the same reform, the Administration has already imposed a Medicare payroll tax on capital income and it wants to repeal the Bush tax cuts for capital gains, dividends and estates. Further, the Administration is hinting, none too subtlely, that it would like to impose a hefty consumption (VAT) tax on the entire population!

What is the Relative Importance of Relative Status? To say that status is important is one thing. (Isn't it the theme of just about every Tom Wolfe novel?) To say it is the only thing that is important at the margin is another. My 8,000 square foot house may give me more status than a 5,000 square foot one. But it also gives me room for an indoor swimming pool, a racquetball court or a state-of-the-art home theater. If everyone were forced to go from 8,000 to 5,000, relative status would remain the same but my utility would go down because I would be forced to give up other consumption that I enjoy.

So how can we sort out and measure the relative importance of status? David Henderson has a brilliant idea. Let high-income people (and only high-income people) vote on whether to tax themselves. This avoids the transaction costs problem and gets to the heart of the matter very neatly.

Do we have any reason to believe the vote would be positive? I think not. Although a lot of high-income people voted for Barack Obama, a lot of those same people are making frequent trips to Washington to lobby against paying more taxes.




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